Making Your Dream a Reality: Finance Your Start-up With the Right Mix of Capital
If you’re planning on starting a business, chances are you’ll need some form of capital, which simply refers to the money that finances your business.
One reason for the failure of many small businesses is that they undercapitalize their business. Therefore, it is important that you know how much money you will actually need to start and to run your business until you reach your break-even point—the point when your sales revenue equals your total expenses.
How much money is required to start this business?
How much of your own money do you have for this business?
Do you already own any of the assets needed to start this business?
Do you have family, friends, acquaintances, or others who are willing and able to invest in this business?
Do you have a strong personal credit rating or lines of credit available?
Equity means ownership. With equity investment, an investor makes money available for use in exchange for an ownership share in the business. If you use equity investment, be sure to consider how much ownership you’re willing to give up, and at what price. Once you sell 51 percent of your shares, you lose control of your company.
Equity investment includes any money from individuals, including yourself, or other companies in your business. This money may be from personal savings, inheritance, personal loans, friends or relatives, business partners, or stockholders. These funds are not secured on any of your business assets.
But, before going down this road, it is important to know the BC laws that apply to any company or other entity that raises money from investors. To find our more read our article: Seeking Equity Investment? Know the Rules
Personal Savings: The Most Common Form of Equity Investment
You’ll likely get most of your start-up funding from your personal savings, inheritances, friends, or family. In fact, according to Statistics Canada’s Survey of Financing of Small and Medium Enterprises 2007, 76% of small businesses in British Columbia financed their business with personal savings.
Aim to fund 25% to 50% of your business from your own pocket. This shows prospective lenders and investors that you are personally assuming some risk, and are committed to your business success. It’s also a requirement for many small business loans, which are usually secured (i.e. backed by assets).
Throughout the course of your business, try to keep a personal investment of at least 25% in your business to increase your equity position and leverage. The more equity your business has, the more attractive it makes you to banks that can loan you up to three times your equity.
1. Government Funding
Typically, the most sought-after type of financing is government grants because it’s free money that you don't have to pay back. Unfortunately, a grant might not be an option for your business because not only are there very few grants available, most are geared towards specific industries or groups of people such as youth, women, or aboriginal owners.
The majority of government funding programs are typically loans, for which you'll be required to repay the principal amount plus interest.
2. Commercial Loans
Commercial or personal loans from financial institutions account for the second most common form of financing at 44%.
Long-term loans. Use long-term loans for larger expenses or for fixed assets that you expect to use for more than one year, such as property, buildings, vehicles, machinery, and equipment. These loans are generally secured by new assets, other unencumbered physical business assets, and/or additional stakeholder funds or personal guarantees.
Short-term loans. Short-term loans are usually for a one-year term or less, and can include revolving lines of credit or credit cards. These are generally used to finance day-to-day expenses such as inventory, payroll, and unexpected or emergency items, and can be subject to a higher base interest rate.
Getting Your Loan Approved: What do Potential Lenders Look For?
Many lenders will look for the four “C’s of Lending” when evaluating a loan application:
Cash flow. Your ability to repay the cash you are borrowing. This is measured using the cash flow forecast that you created for your business plan.
Collateral. The value of assets that you are willing to pledge for assurance that you will repay your loan. A dollar amount will be placed on these assets and that will be compared to the amount of the loan you requested.
Commitment. The amount of money that you're committing to your business. You can’t expect to obtain a loan without contributing a fair share yourself.
Character. Your personal credit score and history with the financial institution. Your credit rating or score is calculated from your history of borrowing and repaying bank loans, credit cards, and personal lines of credit. Without a good credit rating, your loan prospects decrease significantly.
A lender might determine how much to lend you by evaluating your cash flow, collateral, and commitment. They will then subtract your existing debt to arrive at a final amount. Note that lenders look at the limit on your credit cards, not the amount you're currently using.
Typically, start-ups are not rich in assets so you may be required to secure your business loans with personal collateral such as your house or vehicle(s).
The difference between a private lender and a government program is the relative importance of these four C’s. A bank might place more importance on “collateral” and “commitment”, whereas a government program can often decrease the need for these by providing a government guarantee to the lender.
Make a Good Impression With Your Lenders
You can increase your chances of securing a loan by:
Having strong management and staff
Showing steady business growth potential
Showing reliable projected cash flow
Having a strong personal credit rating
Always making your loan and interest payments on time, and never missing a payment